Ticking Inflation Bomb

The front page of the New York Times on 1/6/09 passed on to the public a warning from President Elect Barak Obama. He warned that trillion-dollar deficit spending by the government will likely happen for “years to come”. This spending is supposed to fund the great economic rescue. Barack Obama also acknowledged the burden that this will have on future tax payers.

Most of the money in the world’s failing economy has been invested in US government bonds. These bonds are one of the best ways to keep money safe in times like these. Average Americans don’t have the money to invest in government bonds. If they did, then the economy wouldn’t be in this mess. Wealthy investors now own most of the government’s debt. They fund the government’s deficits. And they will try to sell it when better investments become available.

When the economy finally recovers, these creditors will take back their loans to the government and invest in companies that are poised to supply consumer demand. Investors simply will stop buying new government bonds. At that time there will be only four options for the government: default, raise taxes to pay off maturing bonds, reduce government spending, encourage inflation to make debts worthless.

The United States government defaulting on it’s debt would severely inhibit its ability to run future budget deficits for bailouts. Too many investors won’t buy government bonds if they are not guaranteed. Without funds from government bonds to pay for deficit spending, the United States would be forced to create extra money.

Raising taxes to keep up with the demands from government creditors will be, well, taxing. The effect will stunt economic growth. That defeats the whole point of using government debt to get the economy growing again.

Reducing government spending during an economic recovery is politically problematic. It would stunt economic growth when it is still needed. Government deficit spending is supposed to be what rescues this economy.

Creating extra money, even to pay for bonds, causes inflation. Normally, that discourages both saving and long term investing. Money needs to be spent before it looses much value. So consumers cannot save for major purchases. Commodities get hoarded. In the extreme, a primitive trade and barter economy emerges as the currency becomes worthless.

The good thing about inflation is that the value of debts also decrease with time. As the value of the currency drops, so does the value of the debt based on that currency. Wages go up during inflation. So a borrower will have more money to pay for a debt that is worth less.

For many reasons the result of trillion-dollar deficit spending will inevitably be high inflation. Taxes will not be enough to pay back the bonds used to rescue the economy. The sale of new bonds will not be enough to roll over that debt. Without income from either new taxes or enough new bond sales, the government cannot run a budget deficit. Severely reducing government spending to balance the budget is politically problematic. Eventually, the government will be forced to create extra money to pay its bills.

When the economy finally begins to recover, hoarded cash approximately equal to what investor’s withdraw from the government bond market plus the bailout monies that have been squirreled away will suddenly be dumped into other markets in a spending spree. The supply of goods will not be able to meet demand. Various market bubbles will inflate and pop as investors desperately try to beat inflation. And as the inflation spiral tightens, the spending frenzy will increase.

The government will have several tools available for slowing down the demand driving the inflation when it comes. It could reform the banking system and raise interest rates. But that won’t remove the excess money that would already be in circulation. Taxes can also be used to take excess money out of the economy. But taxes have notoriously uneven effects. And they are not nimble enough to cope with economic changes. There will be few practical options for the government to stop that runaway inflation.

Severely reducing government spending at that time may be a practical option. Not many Americans or businesses would need to continue receiving government assistance. The economy would no longer be dependent on government spending. And the extra goods, labor, and services available to the rest of the economy after government spending cuts would help increas the supply needed to keep demand under control. It would also reduce the flow of money into the economy. It would be a perfect time to reform government.